During Stock Market Rebound, Volatility Is Taking a Holiday

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The five-week rally on Wall Street has been accompanied by a pronounced drop in the market's main fear gauge.

Since the March 5 low, the Chicago Board Options Exchange's Volatility Index (Chicago: VIX) has fallen a stunning 28 percent. That move has been a direct inverse to gains in the stock market, as the Standard & Poor's 500 has picked up 20 percent in a rally that has run almost unabated for more than five weeks.

"The maket actually really took off when the VIX broke its 200-day moving average on the downside," says Dave Rovelli, managing director of US equity trading for Canaccord Adams. "There's more confidence coming back into the market. People are willing to take more risks."

The VIX is calculated from S&P index options and measures expected volatility over the next 30-day period. The gauge generally moves in the opposite direction of the S&P. Its most recent closing high was 50.17 following the March 5 selloff.

As a rule of thumb, traders take the value of the VIX and divide it by 16 to measure the likely percentage swing in the S&P for the month.

Wall Street watches the gauge closely to test investor sentiment. Some analysts view the drop as indicative of a more positive mood in the market, but warn that the number is still relatively high and investors need to stay cautious.

"We are still not out of the woods," Kevin Gardiner, head of global equity strategy at HSBC Bank, said in a research note. "Earnings have yet to trough, and there is surely more financial debris still to surface."

Indeed, even after falling as much as it has, the index remains at what is historically considered a high level.

During the peak of the credit crisis the VIX hit just shy of 90. But a reading past 20 generally represents substantial volatility, while over 30 is considered very high.

That means investors can still expect swings in the market, though perhaps not as manic as some of the darker days of the most recent bear market.

Get Latest VIX Reading and Other Market Quotes

"People ought to be looking for opportunities," says Tom Busby, CEO of the Diversified Trading Institute. "It's not like it was years back when it was like watching paint dry."

As Busby points out, periods of high volatility also can mean an excellent chance to make profit for traders able to move in and out of positions quickly.

"I love these kinds of periods," he says. "If you look at the VIX over time, you'll see periods of higher readings and you'll see periods of stability. There's opportunity in both. You've just got to change your strategy for what's happening in the markets."

As indicated by futures trading, the current level of the VIX is expected to hold for several months. VIX futures are trading at a premium to spot VIX prices and are in lockstep with contracts for May, June and July at about 38.30.

Rovelli says some traders would like to see the VIX move below 30 as a stronger measure that confidence has returned to the market.

But others say the move lower is a strong indication that investors are believing again in stocks.

"Since the March low, investors' appetite for risk and willingness to put the recession behind them has led many of them to believe that there will be no new market low," says Andrew Wilkinson, senior market analyst at Interactive Brokers Group in Greenwich, Conn. "As a result, implied volatility reflected by the VIX is slipping."

The hand-in-hand movements of a lower VIX and higher market indicates that the S&P has steered a clear path away from its March intraday low of 666, Busby says.

"People have hope again," he says. "We've seen our low and we're going to go higher."